Monday, 28 April 2008

How to reward CEOs and other top executives is an ongoing area of discussion and research. Often it is claimed, of course, that executive compensation should be closely tied to the performance of the firm (but that stock options – an often-used way of rewarding executives – are quite imperfect, for instance because they can be exercised over an extended time regardless of performance).

Yet, it is not easy to measure “the performance of the firm”. Performance in terms of what? And performance over what period? Therefore, a decade or two ago, the use of so-called “long term incentive plans” came about; simply put, top executives receive rewards (in the form of stock or cash) on specific dates dependent on whether specific performance goals are met. Such incentive plans are thought to much more precisely link rewards to managerial performance, encouraging executives to direct their attention to long-term profitability rather than short-term gains.

The stock market (that is, investors and analysts) loves them. Ample studies in financial economics show that when firms announce the adoption of long-term incentive plans (for example through press releases or proxy statements), their stock price immediately shoots up. Managers may not always like them – getting rewarded (or not) based on very specific targets at very specific points in time sort of spoils the fun a bit – but it was also hard to resist them; not adopting one of those thingies made you look “illegitimate”. Hence, the top managers of many firms decided to adopt them after all.

Professors James Westphal and Ed Zajac decided to study the stock market effects of these long-term incentives plans once again, but they did something more. First, as expected, examining 408 large US companies, they too found that adopting firms’ share prices went up immediately when they announced that they were going to install such an incentive plan.

Yet, then Jim and Ed also examined whether it mattered how you worded the announcement statement. Specifically, they measured whether the firm's justification for adopting the incentive plan explained that it did so to tie CEO compensation more closely to shareholder wealth (that is, “all the right reasons” for investors; for instance Alcoa did this), instead of a more general description, for instance some sort of HR description (“this plan enhances our ability to attract talent”; AT&T) or no explanation at all. And they found that upon announcement, the stock price of the firms “who used all the right words” went up with 2.4%, while the stock price of the other firms announcing the same plan (but using some other type of explanation) only increased with half of that (1.2%). That is, double benefits from the same thing, by only choosing your words a bit more carefully! That’s easy money.

Then though, it got really interesting. Next, Jim and Ed examined what happened to the stock price of the firms that announced that they were going to adopt a long-term incentive plan but, subsequently, did not actually do it… (a whopping 52% of firms did this!).

This is what they found: First, they found that the stock price of those firms went up on announcement of the plan just like it did for the others (and why not, the stock market could not yet know they were not actually going to implement it!). Then Jim and Ed measured what happened to the stock prices the week following the announcement (when they still had not actually adopted the scheme): nothing; stock price was still up. Then they measured what had happened after a month; stock price still up… Then they measured the outcome after a full year; stock price still up…!

Stock prices went up after announcing the incentive plan. Stock prices did not go down even when the firm subsequently did not actually implement the scheme! Speaking about easy money!!

Is the stock market stupid, or what?! Well… perhaps the answer partly is ‘yes’… but it is probably also a bit more subtle than that. Apparently you and I, investors and analysts, care about firms using the right language but we care much less about what they actually do. Hence, we reward their symbolic behaviour, rather than their real actions. We may not even be fully aware of it but that’s what we value: unlike Caesar's wife Pompeia (who, according to Caesar, not only had to be virtuous but also appear virtuous), we want a firm to appear virtuous; yet we don't care whether she really is!

Friday, 25 April 2008

What do you think pharmaceutical companies spend most of their money on? R&D: the search for new drugs? Think again.

True, pharma companies spend a great deal on R&D; studies show it comprises about 14% of their revenues. Yet, they spend about 1/3 of their revenues on Marketing. That’s right, on average, pharmaceutical companies spend two to three times as much on the Marketing of a drug as on its development. (Hence, next time you hear a pharma executive claim they need to charge such a high price for drugs because of the high costs of R&D, do frown at him fiercely!)

By far the largest chunk of these marketing expenses are taken up by the practice of “detailing”; that is, a vast army of company representatives visit physicians to shower them with information, free samples, and persuasive arguments (and a “healthy dose” of free gifts and travel), claiming that the company’s drug is wonderful and really does what it says on the tin. The raison d’etre of this practice is that physicians – human as they (often) are – only remember and hence only prescribe a limited number of drugs; much fewer than are in existence. Therefore it is important for a pharma company to make sure that physicians know their drugs; they’ll hammer them into their brains (with brute force if necessary!).

Moreover, over the last decade or so, the army of representatives has been expanding with particular vigour. For example, in the US alone, between 1996 and 2000, the herd of quacks with their suitcases full of pills and ointments rose from an already impressive 41,800 to a fearsome 83,000 pharma-suits.

Yet, is this practice of “detailing” really effective? Mwa…(at best).

Research has shown, for example, that on average it takes 3 visits to induce one new prescription. It also takes an average of 26 additional free samples to generate one additional prescription. Hardly impressive I’d say.

Then why do most pharmaceutical companies continue to rely on detailing? Well, there are also studies – mostly internal research by the pharma companies themselves – that do not provide unambiguous evidence that detailing does not work. Hence, they’re just not 100% sure that it is an outdated practice. They fear there is a risk that if they stop using the practice they will lose money. And that’s a risk they’re not willing to take.

“But”, you might add “they’re currently also at risk of losing money because they are continuing the practice”. And of course you’d be right. However, we know from research – for example on variations of “prospect theory”, by Nobel Prize winners Kahneman and Tversky – that people are often a lot more comfortable with the risk of losing money when everybody else is making the same mistake than with the risk of losing money when they’d be the odd one out (even if the latter amount is considerably less than the former).

For example, if a company were to stop detailing but it turned out they were wrong and they’d lose market share and money as a result of it, we (the public) would say “you’re stupid (nobody else did it)”. Currently, firms might be losing (a lot more) money because they continue detailing but now none of us say they’re stupid; because everybody is still doing it and we’re just not sure that the practice is not effective. Hence, the risk of breaking the mould is perceived to be much higher than an undue acceptance of the status quo.

It is a situation very similar to that of the newspaper companies who were reluctant to switch to a tabloid-size format 5-10 years ago: they were just not sure that small size newspapers would catch on. Hence, while everybody was printing broadsheet, nobody dared take the plunge and make the paper smaller.

It takes someone to break the mould and show the way. Usually, that is an outside entrant or a firm in financial distress (who just had to take a risk) – just like the Independent was in financial distress when they were the first to launch a small-size newspaper. Since those scenarios (outside entrants; financial distress) are rather unlikely in the world of pharma with its large entry barriers and deep pockets, detailing may just be with us for quite a bit longer.

Tuesday, 22 April 2008

Don’t ask why, but I have long been interested in what makes certain companies better at innovation than others. Research shows that it is actually not that easy to remain innovative. Once a firm becomes profitable, over time, it is as if the organisation loses the urge to be really innovative and creative, and come up with truly new products and services.

Therefore, one of the things I always ask the executives of a company whose innovation process I am examining is “why do you want to be innovative?” Invariably, the answer is that they realise they need to innovate in order to remain profitable in the long run.

And this is a good point. You may be profitable now, but if you wait to invest in innovation till you see your performance dropping – trying to innovate yourself out of the looming trouble – it may be too late. True innovation has a long lead time; only starting to think about new stuff once your old stuff is beginning to show signs of decay often means you have left it too late. Moreover, by then, you may be out of touch; once you really stop innovating it will be very difficult to get back into it.

All this is of course not rocket-science. Yet, over the past year or so, I have been examining a rather different but also consistently very innovative organisation – as a matter of fact, one of the most innovative organisations of its kind it the world: the famous Sadler's Wells theatre in London.

Sadler’s Wells is a large theatre (their main auditorium takes about 1900 people) which is focused on modern dance. And they host and (co)produce some of the most innovative productions in the world. Moreover, they manage to consistently attract large audiences and are – which is quite rare for such a theatre – financially self-sufficient, very healthy and sound.

When I was talking to their managing director (Chrissy Sharp) and chief executive (Alistair Spalding) – about their many productions, how they organise them, the relations between the theatre and the artists, etc. – at some point I also asked them my usual question: “why do you want to be innovative?” They both stared at me in silent disbelief…

While I was pondering whether they might be wondering whether I was serious (or mad), thinking it was just an incredulously stupid question, or considering to stop the interview immediately, Chrissy finally stammered “but… because we have to… it is what we do”.

Then it dawned on me, they had never even considered the question before.

And gradually, speaking to many more people in the organisation, I figured out that there is a subtle yet fundamental difference between Sadler’s Wells’s commitment to innovation and that of many of the businesses I’ve seen. Companies invariably see innovation as a means to an end; you have to innovate in order to remain profitable. Sadler’s Wells theatre views it the other way around; you have to make a healthy profit in order to be able to continue to innovate.

For them, profit is the means and innovation the end. Companies often struggle to remain truly innovative when they are making huge profits; the urge and feeling of necessity just inevitably slips away. Not for Sadler’s Wells; they continue to innovate, and innovate a bit more the more profit they make. It is not the big, tried-and-tested projects that they have been running for years that excite them, but the new, risky, creative productions that no-one in the world has seen before that get their hearts racing. They respect their established projects but invariably use the profit they make through those to invent new stuff.

And I wonder whether not more companies should adopt this stance: where the organisation’s ultimate commitment is to innovation. It is good to make a profit, and ever better to make a lot of profit. But innovation is what keeps you healthy in the long run, and what generally tends to excite your people; employees and customers alike.

Friday, 18 April 2008

True story: Some time ago I was talking to a CEO regarding an acquisition his company had just done. The topic of “integration trouble” came up, and he said, “I’ve figured out how to avoid all such trouble; I just always quickly and completely assimilate the whole thing”. And indeed, after acquiring the company he immediately merged it with the rest of the firm, spreading out all the new people across different departments and offices.

Around the same time, I was talking to an executive (in charge of M&A) at another company, regarding “integration trouble”. He said, “I’ve figured out how to avoid all such trouble; you simply have to leave them alone, and not meddle in”. And that was what he did with his acquisitions; he bought them but subsequently left them completely autonomous in all aspects of the business.

But who is right, and who is wrong? Hey, I am feeling in a positive mood: I am sure they’re both right. Well… and both wrong…

Both strategies, indeed, usually manage to avoid severe integration tensions. Yet, they also prevent value creation. In order to create extra value, beyond the original two companies’ worth, some form of integration will have to take place; otherwise you’re just owning the two companies like any shareholder owns stock (you just bought it at a high price). Similarly, completely assimilating both units will destroy any potential for value creation, since you’re eliminating all differences between the companies, and just increasing the scale of an organization will seldom result in extra value. The differences are the source of potential value.

When Novartis, for example, was created out of the merger of Ciby-Geigy and Sandoz, subsequent CEO Daniel Vasella explicitly set up an integration program to create a new organization, which in many respects was entirely different from anything either of the companies had before. This approach doubled the company’s value in about a year. Similarly, Igor Landau, former Chairman of the merged pharmaceutical firm Aventis, said, “The strategy was to create a new company and not be the sum of the two previous companies. We decided either we create something new or we would pay the price down the line”.

Acquisitions can be useful, but often only if they are utilised to create something new, that the companies could not have done by themselves. Thus, it is tempting to avoid (integration) trouble, by either quickly and entirely assimilating an acquired unit or leaving it completely autonomous. But sometimes you have to bite the bullet; integration troubles can also be the symptoms of a much more healthy process, of organisational revitalisation and the creation of new value.

Monday, 14 April 2008

Icarus was a figure in Greek mythology. Together with his father, Daedalus, he was held prison in a labyrinth, so obviously had trouble getting out (after all, it was a labyrinth!). Then, Daedalus had a bright idea. He started collecting feathers, that had dropped from the sky (I can only assume from over-flying birds, but anything can happen in Greek mythology) and glued them onto some twigs using beeswax. He made two pairs of wings.

And he told his son, “Icarus, let’s fly out of here!” Initially, Icarus thought “yeah old guy, like that’s going to work; a pair of wings!” But Daedalus said “believe me son, they will work, just try them”. And so did Icarus. He put on the wings and, cautiously, started flapping his arms. And, much to his surprise, he took off!

Icarus was flying, initially quite cautiously but gradually he grew more confident and started enjoying his flight. He started flying higher and higher. His father, Daedalus, shouted “don’t go too high!” but Icarus didn’t hear him (or, more likely for an adolescent, ignored him) and went even higher. Until he started flying too close to the sun…

The beeswax melted, the feathers popped out, and Icarus fell down to earth: Dead (the Greeks are no whimps in their mythology).

This is why we call it the Icarus Paradox; the same thing that had made him successful, escape the prison and fly, is what led to his downfall. In his overconfidence he had become blinded to the dangers of flying too close to the sun.

And this is what we often see very successful companies do too; they become very good and successful doing one particular thing, but this also makes them overconfident and blind to the dangers that new developments in their business pose to them. Which ultimately may lead to their downfall.

Wednesday, 9 April 2008

Who do CEOs think should succeed them? Well, someone like them of course.But then, who do their boards think should succeed the CEO? Well, someone who is much more like the members of the board of course.Then, what does the CEO think should the next board member ideally look like? Well, someone quite like him of course.Does the current board agree with this? No, usually not; they think the new board member should be much more like them.

This sort of sums up the research that professors James Westphal and Ed Zajac (at the time both at Northwestern University) did in the mid-1990s on CEO successors and the background characteristics of newly appointed board members. Surprising it is not – we all like people who are like us, and think that they are so much more competent than the next guy – but I still find it quite striking (if not shocking) how Jim and Ed could so easily uncover evidence of these tendencies using a few simply statistics.

Because they measured some straightforward background characteristics of all of these guys (sorry… yes, usually guys), such as their age, their functional background, education, etc., in 413 Fortune 500 companies. Using these measures, they computed how dissimilar newly appointed CEOs and board members were from the prior CEO and from existing board members.

If the incumbent CEO was in a powerful position (because he was both CEO and chairman of the board, had long tenure, the firm had been performing relatively well, and because there were few outside directors on the board, who owned little stock), incoming CEOs and board members would be much more like the previous CEO – obviously this guy used his powerful position to make sure someone was selected who could be mistaken for his clone. Yet, the reverse was true too; if the board members had more power, they would select someone quite unlike the CEO and much more similar to themselves.

The tricky thing is of course when the CEO succeeds in selecting more and more board members who are just like him. Then the process escalates because board members and CEO start liking the same people! Eventually, everyone in The Firm starts to look alike, talk alike, has the same background, education, taste in cars, dress, entertainment, and so on and so on. Sounds familiar? Know any companies like that? Perhaps you’re employed by a firm just like that (and good chance that you fit in nicely…), or perhaps it reminds you of this phenomenon called “the success trap”, or perhaps – and even worse – both!

Interestingly, Jim and Ed also analysed what happened to the compensation packages that firms offered to their CEO, if the CEO succeeded in selecting more and more people like them. Guess what, the percentage of his pay that was performance related went down, while the total amount of his compensation went up…!

Guess CEOs don’t just like and select people who are just like them, but those people quite like our CEO too! And reward him handsomely for it. After all, obviously, "he does have the most amazing background credentials".

Sunday, 6 April 2008

These things called acquisitions continue to surprise me. Especially how they, quite openly, can get entangled with the personal aspirations and career progress of the companies’ executives.

For example, often it is thinly veiled that the single biggest hurdle to a particular merger, determining whether the deal will go through or not, is the question “who will be in charge” afterwards; the current CEO of company 1 or the CEO of company 2? The proposed merger between Dutch banks ING and ABN-Amro, for instance, was rumoured to have fallen through because executives could not agree on who would take the helm. But are these really good, strategic and legitimate reasons to pursue (or abolish) a deal?! If you didn’t notice: that was a rhetorical question…

Similarly, in 1999, the merger of Viacom and CBS completely hinged on whether CEOs Sumner Redstone and Mel Karmazin could figure out how to distribute responsibilities and power. Eventually, the $40 billion mega-merger – at the time, the biggest media deal ever – seemed to be more of a declaration of love between the two than a move inspired by a clear strategic rationale.

For example, the LA Times referred to "secret meetings" between the two during which Redstone "grew to see the magic of the marriage Karmazin was proposing", while The New York Times quoted Redstone saying of Karmazin: "He is a master salesman, and he began to turn me on", also referring to "a marriage that was consummated after a two-year flirtation and a brief but painstakingly intense two-week prenuptial discussion. ‘Mel seduced me’," Redstone dreamily told reporters and investors after the merger was announced, sounding for all the world like a blushing bride.”

Yet, the marriage came to an abrupt end in 2004, when Karmazin left acrimoniously. What turned out to be the case: If old Sumner (aged 81) would have died during Karmazin’s employment contract with Viacom, he would have taken the mantle. Yet, old Sumner didn’t die… And CBS and Viacom split in 2005.

To me, these kinds of negotiations suggest that the logic for a deal may have more to do with advancing the careers of the people in charge, rather than advancing the value of the combined companies. If you’re an investor or board member, I would conjecture that some suspicion may be warranted.

Thursday, 3 April 2008

Some time ago I was interviewing Tony Cohen, CEO of Fremantle Media; they own television production companies all over the world. A programme developed in one country (say, "Pop Idols" or "The Price is Right") may also have potential in another country. I asked him, “how do you decide which programme is right for which country?” He said, “I don’t”.

“Why would I know any better than anyone else?” he continued. “I don’t make these decisions”. But he does make sure to set up a system that enables the organisation to arrive at a good set of decisions. For example, each year, they organise what is called “The Fremantle Market”. It is a one-day event in London, for which Fremantle executives from all over the world fly in. They present to each other their new television programmes, which they have just had commissioned or developed pilots for.

I visited the event this year. Country executives really try to do a good job convincing their counterparts to “buy” their new television programme, because Tony has made sure that if the new production of Fremantle’s company in the Netherlands gets shown on television in the UK, the Dutch subsidiary receives a good commission that goes straight into their P&L. Moreover, the UK company is eager to obtain Fremantle’s best new programmes developed in other countries because if it manages to sell them to television broadcasters in the UK, it also gains a good profit.

Hence, Tony (or anyone else at Fremantle’s head-office) does not decide which programme to invest in and promote as their next international winner, but he sets up the organisational system in order for local people to make their own decisions. This will enable their next global hit to emerge, without knowing in advance which programme that will be. Sometimes he expected it; sometimes it’s a programme that he never thought would see the light of day.

But often that is not the role we expect CEOs to assume. We expect them to make the decisions, quickly and without hesitation or even a drop of sweat.

It reminded me of Andy Grove, when he was CEO at Intel. When Intel, in the 1980s, was in doubt whether to concentrate on DRAM memory chips or on microprocessors, people (employees, analysts, shareholders, etc.) were banging on his door, asking “please Andy, make a decision; are we going for DRAM or for microprocessors? Tell me what to do”. But Andy said, “I don’t know yet. No, I am not going to make a decision; let’s see how things play out”:

“You need to be able to be ambiguous in some circumstances. You dance around it a bit, until a wider and wider group in the company becomes clear about it”.Andrew Grove

And that’s what he did. He let individual middle managers make up their minds about what they were going to concentrate on. He gave the manager of their production plant a formula, in which he had to input a bunch of data concerning the market, margins, production efficiency, etc. and said “this formula will tell you what to produce (because I don’t know)”. And gradually more and more middle managers started working on microprocessors (instead of DRAMs), and more and more the plant manager’s formula told him to produce microprocessors (and not DRAM). When basically the whole company had switched and chosen for microprocessors, Andy said “now I am ready to make a decision: we’re going to be a microprocessor company”. And everybody said “duh”, because that’s what they had been doing already.

I’d say his “indecisiveness” served Andy rather well, as Intel became one of the most successful and profitable companies in the world for the ensuing two decades. Not by making a tough decision quickly and decisively, but by not making it at all, yet instead enabling the organisation to do it for him - just like Tony Cohen let's his organisation decide what television programmes to promote.

About this Blog

Freek Vermeulen is an Associate Professor of Strategy and Entrepreneurship at the London Business School. FREEKY BUSINESS probes what really goes on in the world of business, once you get beneath the airbrushed façade. It examines the people that run companies – CEOs, managers, directors – and dissects the temptations, the influences and the sometimes ill-advised liaisons and strategies of corporate life.